REIT Preferreds for Rising Interest Rates

6

With all due respect to Bank of America (assuming they again deserve respect), I would argue that, Friday's employment report notwithstanding, the odds favor bond yields (on Treasuries and up and down the quality spectrum) leveling off at current rates. I take a modicum of comfort from recent statements uttered by Pimco's Bill Gross, who seems to believe that while the bond market's best days are behind us, he isn't ready to consign bonds to a massive bear market. Sure, Gross may be "talking his book," but he's still a very bright guy, and has a lot riding on his call.

I referred to Bill Gross' beliefs in a recent blog post I did for SNL about a week ago, which I copy and paste below. It's a long post, so don't bother unless you have five minutes to waste.

Ralph

It’s been a rocky ride. As measured by the MSCI US REIT index (RMZ), equity REITs fell a sickening 16.1% from their closing peak on May 21 to their close on June 20, and then made up some of their losses in the last third of June – rebounding 5.4% through Friday’s close. The culprit, of course, was the trashing the bond markets absorbed during that time period; since May 1, the yield on the Moody’s Baa bond index has spiked almost 135 bps. I’ll discuss later in this post whether that trashing was justified, but Dallas Fed President Richard Fisher complained that the market’s response to the Fed’s recent pronouncements might be likened to a pack of feral hogs – who like to attack in packs.

It’s a gross simplification to explain that REIT stocks’ Fall from Grace was due to their being “interest rate-sensitive” – which ignores the fact that commercial real estate owners can do quite well when, as is normally the case, higher interest rates and bond yields are caused by stronger economic conditions. But it is also true that rising borrowing costs can dent private real estate values and thus can negatively impact REIT shares.

So where do we go from here? Will commercial real estate prices, in fact, decline, putting further pressure on REIT stock prices? Has has the market’s reaction to the Fed’s recent pronouncement that it would take its foot off the accelerator if (and as) the economy shifts into a higher growth mode (and if unemployment comes down) run its course? Have the feral hogs gone home? And if the bond bull market is really dead, must rates and yields move inexorably higher? These are, indeed, the $64,000 dollar questions. But to try to answer them intelligently we should explore two key issues, each being dependent upon the other: Are today’s commercial property prices, and current bond yields, reasonable?

There are no obvious answers, of course. While thinking about these key issues, I was pleased to see two very thoughtful pieces, from very intelligent analysts with excellent reputations, arrive in my in-box late last week. One is from Green Street Advisors, the other from Pimco’s Bill Gross. Perhaps because they coincide with my views on these topics (but which is really not a very good reason at all), I would like to review them here.

Green Street is very much aware of the fact that interest rates and borrowing costs have historically impacted commercial real estate values and their cap rates. One might thus reasonably expect that a large spike in interest rates and bond yields would impact these values and “should” reduce the “warranted” prices of REIT shares. But Green Street’s report, authored by Andrew McCulloch, Mike Kirby and Peter Rothemund and entitled, “What Now for Real Estate Pricing” (June 27, 2013), concludes that despite the rise thus far in bond yields, there is no reason why commercial property prices “should” decline.

Their analysis is that investors in these assets have not underwritten prices on the basis of bond yields that existed prior to the recent spike, and that today’s cap rates are appropriate when the Moody’s Baa bond index sits at around 5.4%. The firm says that “total return expectations (i.e., IRRs) to long-term owners of commercial real estate of roughly 6.5% [based on current cap rates and growth expectations] still appear reasonable even after the recent bond market rout,” and is in line with historical spreads between commercial property IRRs and corporate bond yields.

This analysis is persuasive. But all bets are off, of course, should bond yields continue to rise from here – and I am sure that the Green Street guys would agree with that caveat. So, will they continue to rise?

That’s where the next bit of guessing comes into play: Whither bond yields? Have we experienced just the first early phase of a period of rising yields? Has the Fed’s “money-printing” so artificially depressed interest rates and yields that a massive spring-back is our fate? Will the US 10-year Treasury yield move inexorably higher, perhaps pausing at a still historically low 4.5% or 5.0%? In other words, should bond investors (and perhaps REIT investors as well) blow out their holdings and not look back?

These questions, of course, address the key issues that shorter-term investors, at least, should hone in on. And, while nobody has found that ever-elusive crystal ball, I think it would be a mistake to ignore the thoughts of Bill Gross, even though cynics may scoff that the “Bond King” is merely talking his book. In a very recent (June 27) blog post – “The Tipping Point” – Mr. Gross considers the issue of whether bond investors should abandon ship and, as he puts it, “jump overboard and risk the cold money market Atlantic Ocean at near zero degrees.”He explains, in this blog post (which I think should be required reading for everyone) why bond investors should not do so.

At the risk of oversimplifying his views, he believes that the Fed’s forecast for economic growth is “far too optimistic,” that the threat of inflation is grossly overstated, and that bond yields have already, in reality, risen too far. This feels right to me; I have been praying at the Church of New Normal for quite some time, and see no reason to convert to another religion at the present time.

I do not believe that our quasi-secular economic headwinds have abated much, and there is little out there that should cause any meaningful relief. Wage growth has been stagnant, after inflation, from 2010 through 2012; real unemployment (including those who want jobs but aren’t actively looking) is very high (i.e., the labor market participation rate, at 63.4%, has plummeted since the advent of the Great Recession and shows few signs of a rebound); the US personal savings rate has dropped to 2.5% recently, perhaps restricting future consumer sales growth; and businesses remain reluctant to expand or to buy new capital equipment in the face of flat revenue growth, Obamacare uncertainties and perceived increases in government regulation. And I will not even mention longer-term growth-retarding issues such as the pressure of foreign competition, high government and personal debt (and deficits), political gridlock, and geopolitical risks and uncertainties.

Mr. Gross (and I) may, of course, be wrong about all of this, and perhaps 4% GDP growth and 3% inflation is right around the corner. My Golden Retrievers, Riley and Kacie, still haven’t returned my crystal ball. However, to invest in anything other than cash requires that we make assumptions, and act upon them. Any investor who wants a decent return on his or her investment must take risks. To believe otherwise is to believe in the Good Tooth Fairy. And I haven’t seen her hovering overhead recently.